The Federal Reserve controls the stock market. This may sound like a bold statement - and it would have been an even bolder one just a few years ago - but it has rung true since the beginning of the Great Recession in 2007.
As the major indices rise and fall with every note of optimism or speech of caution, the Federal Reserve's influence becomes more and more clear. So, what does the Federal Reserve do?
The Federal Reserve is the central bank of the United States - essentially, it controls the flow of money around the country. The Fed is a totally separate entity from the Treasury, which collects taxes and issues debt. Unlike the Treasury, the Fed cannot be used by the U.S. Government as a policy tool. Congress cannot go to Chairman Bernanke and ask for looser monetary policy. Instead, the Federal Open Market Committee - a 12-member group within the Fed (four of whose members cycle in and out yearly) - decides how to control the government's monetary policy.
The Federal Reserve has three main policy tools: open-market operations, the discount rate and the reserve requirement. To oversimplify, open-market operations and the discount rate both focus on the interest rates that banks charge - these interest rates affect a chain of other interest rates, from savings accounts to home mortgages. The reserve requirement essentially dictates the ratio of capital to debt a bank must keep on hand - 10 percent would mean a bank could loan out $90 for every $100 in deposits.
The Fed's biggest tool, however, began much more recently: quantitative easing. The Fed first instituted quantitative easing when they had pushed their conventional policy tools to near their limit - interest rates simply cannot be lowered below zero. With the post-crash economy barely alight, the Fed needed a new source of fuel to throw on the fire.
Like most of the Fed's expansionary policy, quantitative easing pushes lenders - banks, mortgage issuers and other wary financial institutions - to lend more money. Though quantitative easing - or QE, as the media has dubbed it - has a noticeable effect on interest rates, the program's primary goal is to increase the supply of money that these institutions can lend out. Traditional economic theory posits that lending money will encourage investment, growth and hopefully recovery.
The market crash of 2008 drove investors away from risky assets - like stocks or mortgage-backed securities - and into arguably the safest investment available: the debt of the U.S. Treasury. Instead of holding cash reserves, which they could lend out, banks now held treasury notes. With interest rates already at a low of a quarter of one percent, the Fed pushed banks into loaning money again by purchasing those treasury notes, thereby increasing bank reserves.
The first round of quantitative easing began in November 2008, with the purchase of $600 billion in mortgage-backed securities. After "QE1" ended, the Fed felt that additional rounds of quantitative easing were needed to keep the economy going. QE2 followed, and we are currently in the midst of QE3. This round has earned the nickname "QE infinity," since the Fed has not given an official end date for the policy.
The Fed currently purchases $85 billion in debt per month and recently put off a possible reduction - or "taper" - until at least next month.
The Fed holds more than $3.4 trillion in securities, which breaks down to $1.3 trillion in mortgage-backed securities and most of the rest in Treasury debt.
The Federal Reserve cannot force banks to lend out this money. But when faced with the alternative - slow growth and a recovery that could last decades - the Fed has decided to do everything it can to keep the economy afloat.
Walt Laws-MacDonald is a junior majoring in quantitative economics. He can be reached at Walt.Laws_MacDonald@tufts.edu.
